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As investors, we need to know how the fiscal cliff will affect equity prices.  Obviously there are a range of sentiments aroused by the political brinksmanship, so analyzing one sentiment isn't a perfect proxy.  That said, we think our variables Stress and Uncertainty from the Thomson Reuters MarketPsych Indices are a fairly good proxy for what investors are experiencing.

 

As you can see in this dramatic plot of Stress in news reports about the S&P 500 and its constituent companies, Stress (blue line) is at a 12-month high.  Social media shows a similar spike in the last month, but it is less dramatic (in social media August was the most stressed month).

 

 

 

We performed a quick cross-sectional analysis in which we looked at 40 ETFs tracking the largest indexes, sectors, and industries in North America with high Buzz (lots of chatter) in financial social media over the past 14 years (1998-2012).  We sorted those ETFs by the percentage of that chatter that was Stress-related.  The past 24 hours of Stress was aggregated to 30 minutes before the close today (t) was matched to the percent return from today's Close to tomorrow's Close (t+1).  For each Quintile of Stress days - the highest Stress 20% of days is on top and least Stressed 20% is on the bottom - we averaged the one-day forward return of that ETF. The sample included data from 1998-2012 but largely centered on 2008-2012 due to a higher number of ETFs being available for analysis over that period.

 

One Day Forward ETF Return	Quintiles
0.07%	Highest Stress
0.07%
0.03%	Middle Quintile
-0.01%
-0.06%	Lowest Stress

In the case of Stress, high Stress precedes high return days.  In fact, if this Quintile strategy were tradable (assuming unrealistic zero transaction costs, optimal portfolio formation, a lack of overfitting, etc...), we would see over 30% average annual returns.

 

While the quintiles tell an interesting and potentially lucrative story, the deciles are even more interesting:

 

One Day Forward ETF Return	Deciles
0.14%	Highest Stress
0.00%
0.09%
0.05%
0.05%
0.02%
0.00%
-0.02%
-0.05%
-0.07%	Lowest Stress

 

It looks like greater than 50% average annual returns from this strategy, but I want to be clear that THIS IS NOT TRADEABLE as it is.  The extreme stress days are better at timing reversals.  When many ETFs are hitting extreme stress points at the same time, there tends to be a positive price bounce.  This is a specific timing model, not a portfolio rotation-type model.

 

But while we're at it J lets take a look at Uncertainty.  With Uncertainty we don't see high daily returns. 

 

One Day Forward ETF Return	Quintiles
0.03%	Highest Uncertainty
0.04%
-0.01%	Middle Quintile
0.00%
0.04%	Lowest Uncertainty

Interesting about Uncertainty is that the higher returns occur for both high and low states of Uncertainty.  When Uncertainty is low, markets rise (a little).  When Uncertainty is high, they also rise (a little).  In a subsequent newsletter we'll look at the effect of Uncertainty on prices more specifically, especially how it can be used to profit when seen as an amplifier of sentiment signals.  But more on that later...

 

To understand how the uncertainty and stress of the fiscal cliff negotiations is likely to resolve, it helps to revisit my negotiations with prison bullies.  

The bully who challenged me in prison felt he had the moral high ground and that because of my presumed background (rich doctor), I was less than human.  He usurped my authority to complete his own agenda - getting more physical and economic power among peers. After my first losing encounter, the wisest psychotherapist I know, who is a mentor of mine, told me how to work with him.

 

I was to hold the group again and invite the bully.  According to my mentor, when the group started the bully would again express contempt towards me and attempt to split the group from me, earning him additional political points.  My job as therapist was to remain in a curious state of mind and to aggressively and preemptively call out the bully's behavior. 

 

First of all, when the bully denounced me and prepared to walk out, I was to immediately and calmly say, "I think you're going to leave now."  He couldn't do what I said he was going to do, as my predicting his behavior undermined his dominance.  He would then have to stay in the room to re-establish his dominance before leaving. 

 

Then when he said, "you just don't know anything about our lives!"  I would respond, "you're right, I don't know how hard it is to be you, so tell me, what's it like?"  When he said, "you'll never understand," I was to respond with sincere interest, "Could you help me?"  When he looked frustrated, I was to say, "I get that you're angry, and you want to leave" again preemptively calling out his behavior. 

 

As I acknowledged his position, he HAD to respond in order to stay dominant.  But as I drilled in further with genuine curiosity, he couldn't escape.  As long as I was persistent, authentic, and didn't back down, eventually he would be forced to either answer my questions (and thus engage in therapy) or he would be forced to again leave the group but this time but in the weaker position.

 

Our interaction played out exactly as above, and to make a long story short, in that second session he engaged in therapy.  Later that week he became the group's greatest promoter, rounding up all the group members to attend every session thereafter.

 

But this newsletter isn't about group therapy in prison.  Of greatest relevance is how the fiscal cliff is likely to unfold if bullies bump heads.

 

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